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One of the biggest mistakes entrepreneurs make is not understanding the relationship they have with their investors. At times they confuse VC’s with their friends.

Lets Go to LunchAt Rocket Science our video game company was struggling. Hubris, bad CEO decisions (mine) and a fundamental lack of understanding that we were in a “hits-based” entertainment business not in a Silicon Valley technology company were slowly killing us.

One day I got a call from my two investors, “Hey Steve, we’re both going to be up in San Francisco, lets grab lunch.” I liked my two investors. I’d known them for years, they were smart, trying to figure out the video game market with me, (in hindsight a business that none of us knew anything about and shouldn’t have been in,) coached me when needed, etc. Our board meetings were collegial and often fun.

We were just about to have a board meeting in another week to talk about raising another round of financing to keep our struggling disaster afloat. I had assumed that my VC’s were behind me. Thinking we were having a social call, I was completely unprepared for the discussion. (Lesson – never take a VC meeting without knowing the agenda.)

“Steve, we thought we’d tell you this before the board meeting, but both our firms are going to pass on leading your next round.” I was speechless. I felt like I had just been kicked in the gut and stabbed in the back These were my lead investors. It was the ultimate vote of no confidence. If they passed the odds of anyone in the entire country funding us was zero. I knew they had been questioning our ability to stay afloat as a company in the board meetings so this wasn’t a complete surprise but I would have expected some offer a bridge loan or some sign of support. (I finally got them to agree if I could find someone else to lead the round they would put in a token amount to say they were still supportive.)

“Is this about me as the CEO?” I asked. “I’ll resign if you guys think you can hire someone else you want to back.” They looked a bit sheepish and replied, “No it’s not you. You should stay and run the company. However, we realized that we’ve backed a business we don’t know much about, the company is a money sink and both our firms have no stomach for this industry.”

“But I thought you guys were my friends?!” You’re supposed to support me!! I said out of utter frustration.

VC’s Are Not Your FriendsI had just gotten a very expensive reminder. I liked my board members. They liked me. But while I was just seeing a single board member, I was just one of twenty companies in their current fund portfolio. Their fiduciary responsibility was to manage a portfolio of investments for their limited partners. And what they promised their own investors was that they would invest money in deals that would grow in value and achieve liquidity. As much as they liked me as the entrepreneur, they couldn’t throw good money after bad when they thought the deal went south.

I wish I could tell you I understood this all at the time. I didn’t. I was angry, took it personally for a long time (past the demise of Rocket Science) until I realized they were right.

While the best VC’s treat entrepreneurs like you are their most important customer, and they add tremendous value to your startup (recruiting, strategy, coaching, connections, etc.) they are not doing it out of the goodness of their hearts. Entrepreneurs need to understand that VC’s are simply a sophisticated form of financial investors who in turn need to satisfy their own investors. At the end of the day VC’s have to provide their limited partners with great returns or they aren’t going to be able to raise another fund.

If you succeed so do they. Great VC’s do everything they can to make you successful. But just like your bank, credit card company, mortgage holder, etc. they are not confused where their long term loyalty lies.

It’s not with you.

PostscriptThe irony is 15 years later, no longer doing startups, these two VC’s truly have become my friends. We have lunch often, teach together and swap war stories of the day they pulled my funding.

31 Responses

Interesting. I just had a conversation with the executive team at one of my clients that was related to this subject.

I asked them who they thought their competition was. They naturally started rattling off the names of their company’s competition. I then told them that what I meant was who are they personally being compared with: I received a blank stare (no pun intended.)

I then took out a list of all of the companies that their investors have investments in. On the list was the CEO, VP of Sales and VP of Marketing for each company. I then explained that the investors are comparing them to everyone on that list and all of the other teams that come in and pitch to them.

I then encouraged them to look at how those teams were managing their businesses and see how they compared. It was actually a pretty intimidating yet sobering moment for them.

They are now taking a very serious look at their sales, marketing and customer development efforts.

Plenty of VCs are good, intelligent, charming, and friendly. But when things are at stake, you learn very quickly what your relationship is about, which we of course should have known anyway. But it’s easy to forget when things are going well.

When they aren’t going well, they become more and more risk averse, and represent their LP interests (and he 2/20 personal interest). How they and we behave when things are tough is a test of our character.

But I’ll say they are equally surprised and shocked when things don’t go their way– founders make a significant move (change the CEO, reject financings, etc). It goes both ways.

So communication and understanding and respect of each other’s interests is paramount.

Hi Steve – Thank you for sharing this experience, it must have been a painful, yet necessary lesson at the time.

I really enjoyed the part of the story where you offered to resign to save the company. This demonstrated a willingness to sacrifice for your team and ultimately your company. I imagine that must have been a difficult thing to do, yet such an authentic gesture likely had an amazing impact on solidifying team loyalty.

The REAL problem with Rocket Science was simply being too far ahead of its time. It was stunningly brilliant and all those looking in from the outside were scared. There’s another post in that … An East Coast VC would have played it more ruthlessly, count your blessings!

Gotta disagree with you, Matt. Those of us who had already figured out how to ship successful video games could tell that the titles Rocket Science were cranking out were misguided; they were all flash and no gameplay (which Steve covers in his posts.) The impolite comment would’ve been, “What are they smoking?”

It’s actually pretty common – smart people from other tech fields look at these “trivial games” and figure they can not only make them, but much better than the people who are doing it now. Millions of dollars later, they close up shop.

Steve, great post. The reality is a bit more complex but you nailed the pragmatic gist of this dynamic. We VCs (assuming we sit on the boards of our portfolio companies) often have the awkward tension between our fiduciary duties to our LPs and our fiduciary duties as a board director. If you do this dance long enough and look deep, you realize that the alignment of those duties is “optically skewed” but ultimately about maximizing shareholder returns.

This is pretty useful advice for green horn entrepreneurs who are likely to believe too much in the personal charm of VC’s, some of whom are really good at it. You are right that ultimately VC’s have to earn their bread the same way startups need to do.

They didn’t just do right by their LPs by deciding not to lead the round or invest, they did right by you.

When you’re in the drivers seat it’s hard to accept that your car is dying, and you’ve gone off the super highway and are spinning your wheels stuck on a boulder. They helped you realize that it was time for Rocket Science to spin down and move on to greener pastures, which you obviously discovered in spades.

Appreciate your wisdom as always Steve, and got a chance to link to your history of risk investments today in a post.

“Great VCs do everything they can so that Exceptional Entrepreneurs have the tools they need to build Great Companies”

We back Exceptional Entrepreneurs on the premise that the Founders are the ones with the passion and vision to get a Company through the real tough times as well as adapt to take advantage the true opportunities. The Founders don’t need to be the CEO, but they are who we back.

That being said, if, as an investor, I don’t understand the market that is then being addressed, the players, the opportunities and challenges, my intrinsic value as a VC becomes null. I have limited time and limited capital. Thus, it becomes a reason to back out. Even thought the entrepreneur is awesome.

Not that much different then building a successful management team: you need the right people at the right time in the right position.

An Entrepreneur needs the right investors, at the right time providing the right resources.

Steve, I think the content of this piece is spot-on, but the title misses the mark. Someone can be your friend and still decline to give you money that they know you’re going to piss away.

The decision to stop funding an existing portfolio company is one of the hardest that a VC makes. It’s uncomfortable and unfortunate, but absolutely critical to effective fund management. The good ones say something like, “Steve, I know you’re doing all you can and I’m going to continue to provide support and assistance, just not in monetary form.” And then they walk the walk.

On the flip side, isn’t it really naive to expect a VC to nonchalantly dole out money that had been entrusted with them, without regard for expected return?

You can have a good friend who is a pharmacist. Just because they refuse to dispense pharmaceuticals to you does not mean they’re not your friend.

Steve,
Great story! Thank you for sharing. I am wondering if you were upfront with your VCs and outlined certain goals that the company had to meet in terms of revenue, profit, # of customers, etc. and you surpassed them, would the story be the same?

I feel like a lot of companies in the new unexplored industries, in their early stages face similar challenges that Rocket Science faced. However, great leaders like yourself will always know where to pivot and find the way out. I mean look at stories of YouTube (initially a video dating site), PayPal, EMC and many other companies who came into the market with one idea and one service, but grew to become something completely different.

A friend of mine started a company in custom jewelry business, initially by offering a platform for jewelry stores, after burning through $5.8 million, he pivoted into moving his entire business online, raised another $5.2 million from the same VCs and now the company is doing really well. I am wondering how is his experience different than yours? And what can an entrepreneur do in order to make sure that VCs have confidence in him even when the ship is sinking? Would we have to surpass all of the goals and truly “wow” them with our execution ability?

I loved your second paragraph about being in the hit-based entertainment industry, instead of technology. This drives me nuts. I run into people who insist that they are in technology, but they don’t sell technology. They use it. They sell something else. Sorry, you are in the industry that sells what you sell.

As far as VCs go, they killed one company I worked for. Lesson learned. Thanks for evangelizing that point. VCs are no more your friend as any employment recruiter or anyone else selling you something.

Here is Basil Peters talk entitled “Don’t Blow the Biggest Deal of Your Life” about being an entrepreneur CEO of his first technology company and a number of lessons learned about dealing with VC on his board when the entrepreneur and VC’s interests aren’t aligned.

It’s a great story, and a great lesson: Friendship may not the most important thing (or even relevant) when money is involved. A related lesson has to do with lawyers–you might think that you’re great friends with your lawyer, but if someone else (a partner or investor) is actually paying them, the lawyer will protect their interests when a conflict occurs.

Great insights from an entrepreneur and can’t be truer. I fell into this trap several times myself and have spoken to other entrepreneurs about the same issue. The mistake many of us make is that investors, not just VCs, are “angels out of the sky”. They’re not. Whilst many carry experience and money – they’re still in it for the investment. Trevor

This is a great post and one that any person associated with a venture backed company should read and re-read. A company’s VC’s are not your friends, this is business.

This post really hit home for me. Almost exactly one year ago, our investors decided not to move forward with our Series C and we had to wind down the company.

Fortunately, our VCs handled it with class. As such, I would be happy to work with, or recommend, any of them again.

Your post inspired me to write a summary on the event. See http://jhelmig.tumblr.com/ for the unabridged version of the story as well as the top 5 things I think we did well and top 5 I would do differently if I could.